THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 240

208 PA R T I I I FYI Financial Institutions Canada s Asset-Backed Commercial Paper Saga As we noted in Chapter 2, commercial paper is short-term, unsecured debt issued by corporations, typically for financing accounts receivable and inventories Asset-backed commercial paper, like traditional commercial paper, is also a short-term security (with a maturity that is typically less than nine months) It is issued by conduits (that is, bankruptcy-remote Special Purpose Vehicles), but instead of being an unsecured promissory note, is backed by physical assets such as mortgages, trade receivables, credit card receivables, automobile loans and leases, and other types of assets Because of this backing, the quality of the ABCP depends on the underlying securities and thus ABCP could be very risky For example, if there are negative developments in the underlying markets, the risk of ABCP will increase and investors will switch out of ABCP and into safer money market instruments such as traditional commercial paper, bankers acceptances, and Treasury bills As a result, conduits will not be able to roll over their ABCP and will face a liquidity crunch The ABCP market in Canada expanded very rapidly from the 1990s to 2007 As at July 31, 2007, the size of the Canadian ABCP market was $115 billion (equal to about 32.5% of the Canadian money market), of which $80 billion was bank-sponsored and $35 billion was non-bank-sponsored At the same time, the ABCP market in the United States was approximately US$1.2 trillion, equal to about 50% of the U.S commercial paper market Bank-sponsored ABCP conduits are invested in plain vanilla assets such as residential mortgages and credit card receivables Non-bank-sponsored ABCP conduits are invested in structured finance assets such as collateralized debt obligations (CDOs) and subprime mortgages Canadian banks are involved in the distribution of ABCP and also provide liquidity back-stop facilities to nonbank-sponsored ABCP conduits under the so-called general market disruption clause In August of 2007, investors in the Canadian ABCP market declined to roll over maturing notes because of concerns about exposure to the U.S subprime mortgage sector in the underlying assets As a result, the market was divided into those ABCP conduits that could honour their obligations (bank-sponsored) and those that could not honour their obligations (non-banksponsored) In the case of bank-sponsored ABCP, the Big Six banks took back onto their balance sheets significant amounts of their own sponsored ABCP Moreover, valuation and fair-value issues led to significant write downs in the fourth quarter of 2007 and the first quarter of 2008 In the case of non-banksponsored ABCP, a number of conduits faced significant liquidity shortages, seeking liquidity funding support from their liquidity providers (banks) However, major liquidity providers denied requests for liquidity support, arguing that the general market disruption clause was not met They interpreted the clause to mean that the majority of the conduits in the entire Canadian ABCP market would need to be unable to roll over before a liquidity provider had to step in As a result, the Canadian non-bank-sponsored ABCP market froze and investors, including Quebec s huge pension fund, Caisse de d p t et placement du Qu bec, Alberta s ATB Financial, the National Bank of Canada, and about 2000 individual small investors, had their cash frozen in non-bank-sponsored ABCP At the time, the Bank of Canada indicated that it would not accept ABCP as collateral for loans to banks and that a solution from participants in the ABCP market was deemed to be appropriate As a result, major market participants, including non-bank-sponsored ABCP conduits, institutional investors, liquidity providers (ABN AMRO Group, HSBC, Deutsche Bank, Merrill Lynch, Barclays Capital), and the Affected Trusts, reached an agreement on August 16, 2007, known as the